GAO: 68% of S Corp Tax Returns Have Errors

The Government Accountability Office today released Tax Gap: Actions Needed to Address Noncompliance with S Corporation Tax Rules (GAO-10-195):

According to IRS data, about 68% of S corporation returns filed for tax years 2003 and 2004 (the years data were available) misreported at least one item. About 80% of the time, misreporting provided a tax advantage to the corporation and/or shareholder. The most frequent errors involved deducting ineligible expenses, which could decrease S corporation shareholder tax liabilities. Even though a majority of S corporations used paid preparers, 71% of those that did were noncompliant. Stakeholder representatives said that preparer mistakes may be due to the lack of preparer standards as well as their misunderstanding of the tax rules. Shareholders of S corporations also made mistakes in calculating basis – their ownership share of the corporation – when taking losses passed to them from the corporation, potentially decreasing their total taxes. IRS officials as well as stakeholder representatives said that calculating and tracking basis was one of the biggest challenges for shareholders, and that S corporations themselves were in a better position in most cases to calculate basis for their shareholders.

To improve compliance with shareholder basis rules, Congress should require S corporations to calculate and report shareholder’s stock and debt basis as completely as possible. S corporations would report the calculation on the Schedule K-1 and send it to shareholders as well as IRS. If Congress judges that stock purchase price information that is currently only available to shareholders should not be transmitted to the S corporation due to privacy concerns, an alternative is to require that S corporations report less complete basis calculations using information already available to the S corporation.

To help address the compliance challenges with S corporation rules, we recommend that the Commissioner of Internal Revenue take the following four actions:

• Identify and evaluate options for improving the performance of paid preparers who prepare S corporation returns, such as licensing preparers and ensuring that appropriate penalties are available and used.
• Send additional guidance on S corporation rules and record-keeping requirements to new S corporations to distribute to their shareholders, including providing guidance on calculating basis and directing them to the specific IRS Web site related to S corporation tax rules.
• Require examiners to document their analysis such as using comparable salary data when determining adequate shareholder compensation or document why no analysis was needed.
• Provide more specific guidance to shareholders and tax preparers, such as that provided to IRS examiners, on determining adequate shareholder compensation through means such as IRS’s Web site.

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